Sunday, November 30, 2014

In a fascinating passage from Alfred Marshall’s The Economics of Industry (1879) (which he wrote with his wife Mary Marshall):

“The connexion between a fall of prices and a suspension of industry requires to be further worked out.

There is no reason why a depression of trade and a fall of prices should stop the work of those who can produce without having to pay money on account of any Expenses of production. For instance a man who pays no wages, who works with his own hands, and produces what raw material he requires, cannot lose anything by continuing to work. It does not matter to him how low prices have fallen, provided that the prices of his goods have not fallen more in proportion than those of others. When prices are low, he will get few coins for his goods; but if he can buy as many things with them as he could with the greater number of coins he got when prices were high, he will not be injured by the fall of prices. He would be a little discouraged if he thought that the price of his goods would fall more than the prices of others; but even then he would not be very likely to stop work.

And in the same way a manufacturer, though he has to pay for raw material and wages would not check his production on account of a fall in prices, if the fall affected all things equally, and were not likely to go further. If the price which he got for his goods had fallen by a quarter, and the prices which he had to pay for labour and raw material had also fallen by a quarter, the trade would be as profitable to him as before the fall. Three sovereigns would now do the work of four, he would use fewer counters in measuring off his receipts against his outgoings; but his receipts would stand in the same relation to his outgoings as before. His net profits would be the same percentage of his total business. The counters by which they are reckoned would be less by one quarter, but they would purchase as much of the necessaries, comforts, and luxuries of life as they did before.

It however very seldom happens in fact that the expenses which a manufacturer has to pay out fall as much in proportion as the price which he gets for his goods. For when prices are rising, the rise in the price of the finished commodity is generally more rapid than that in the price of the raw material, always more rapid than that in the price of labour; and when prices are falling, the fall in the price of the finished commodity is generally more rapid than that in the price of the raw material, always more rapid than that in the price of labour. And therefore when prices are falling the manufacturer's receipts are sometimes scarcely sufficient even to repay him for his outlay on raw material, wages, and other forms of Circulating capital; they seldom give him in addition enough to pay interest on his Fixed capital and Earnings of Management for himself.

Even if the prices of labour and raw material fall as rapidly as those of finished goods, the manufacturer may lose by continuing production if the fall has not come to an end. He may pay for raw material and labour at a time when prices generally have fallen by one-sixth; but if, by the time he comes to sell, prices have fallen by another sixth, his receipts may be less than is sufficient to cover his outlay.

We conclude then that manufacturing cannot be carried on except at a low rate of profit, or at a loss, when the prices of finished goods are low relatively to those of labour and raw material; or when prices are falling, even if the prices of all things are falling equally.

§6. Thus a fall in prices lowers profìts and impoverishes the manufacturer: while it increases the purchasing power of those who have fixed incomes. So again it enriches creditors at the expense of debtors. For if the money that is owing to them is repaid, this money gives them a great purchasing power; and if they have lent it at a fixed rate of interest, each payment is worth more to them than it would be if prices were high. But for the same reasons that it enriches creditors and those who receive fixed incomes, it impoverishes those men of business who have borrowed capital; and it impoverishes those who have to make, as most business men have, considerable fixed money payments for rents, salaries, and other matters. When prices are ascending, the improvement is thought to be greater than it really is; because general opinion with regard to the prosperity of the country is much influenced by the authority of manufacturers and merchants. These judge by their own experience, and in time of ascending prices their fortunes are rapidly increased; in a time of descending prices their fortunes are stationary or dwindle. But statistics prove that the real income of the country is not very much less in the present time of low prices, than it was in the period of high prices that went before it. The total amount of the necessaries, comforts and luxuries which are enjoyed by Englishmen is but little less in 1879 than it was in 1872.” (Marshall and Marshall 1879: 155–157).

So already in the 1870s Marshall says that wages are liable to be inflexible downwards, or at least there is a lag between price deflation and nominal wage cuts that reduces profits and causes business pessimism.

Also very striking is that Marshall is well aware of the essence of debt deflation, but not, I think, how damaging debt deflation can be, and how business pessimism arising from deflation, debt deflation and profit deflation can reduce the aggregate level of investment and hence the aggregate wealth and employment of a nation, for the reasons outlined by Keynes in Chapter 19 of the General Theory. An equally serious flaw is that Marshall also continued to defend Say’s law in the form expressed by John Stuart Mill (Marshall and Marshall 1879: 154).

However, Marshall thinks that mild to modest inflation actually increases the confidence of business people because their profits are rising, a not unreasonable idea at all, and he was right to stress the role of business confidence as a driving force of capitalism and investment (Marshall and Marshall 1879: 154–155).

These issues are very interesting because during the great deflation of 1873 to 1896 it seems clear that business expectations became pessimistic and people at the time spoke of a “profit deflation” that sapped business confidence.

Marshall himself spoke of this in his evidence before the UK “Royal Commission on the Value of Gold and Silver” instituted in 1887.

Alfred Marshall stated:

“[Henry Chaplin, MP:] Do you share the general opinion that during the last few years we have been passing through a period of severe depression? …

[Marshall]: 9823. Yes, of severe depression of profits.

[Henry Chaplin, MP:] 9824. And that has been during a period of abnormally low prices? …

[Marshall]: A severe depression of profits and of prices. I have read nearly all the evidence that was given before the Depression of Trade and Industry Commission, and I really could not see that there was any very serious attempt to prove anything else than a depression of prices, a depression of interest, and a depression of profits; there is that undoubtedly. I cannot see any reason for believing that there is any considerable depression in any other respect.”

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. Appendix, Minutes of Evidence taken before the Royal Commission on Gold and Silver, pp. 21–22.

The evidence would then suggest that downwards nominal wage stickiness was the cause of a “severe depression of profits” and along with debt deflation the cause of business pessimism in these years.

And even if wages did adjust after considerable lags, the nominal fall in money profits may well have been sufficient to cause business pessimism, since business people were probably more focussed on nominal values than the real, inflation-adjusted value of profits (or what neoclassicals call the “money illusion”). And even with wage adjustments in the long-run, businesses were still probably hit by debt deflation.

A final and very interesting question to my mind is this: did the aggregate level of investment in Europe and America fall as the great deflation of 1873 to 1896 unfolded?

S. B. Saul in his book The Myth of the Great Depression, 1873–1896 thought so, and argued that lower industrial investment was a characteristic of this period (Saul 1985: 41, 53).

BIBLIOGRAPHYFinal Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888

Friday, November 28, 2014

“The banks in their lending business are not only not limited by their own capital; they are not, at least not immediately, limited by any capital whatever; by concentrating in their hands almost all payments, they themselves create the money required, or, what is the same thing, they accelerate ad libitum the rapidity of the circulation of money. The sum borrowed to-day in order to buy commodities is placed by the seller of the goods on his account at the same bank or some other bank, and can be lent the very next day to some other person with the same effect. As the German author, Emil Struck, justly says in his well-known sketch of the English money market: in our days demand and supply of money have become about the same thing, the demand to a large extent creating its own supply.” (Wicksell 1907: 214–215).

Wicksell, then, understood well the nature of endogenous money and how the financial and monetary system even of his day was endogenous to a significant degree, and the point that you can’t have an independent, exogenous money supply function that is truly independent if money can come into existence in response to the demand for it. In many ways, Wicksell’s work was an attempt to reconcile the classical quantity theory with the reality of endogenous money, but ultimately it was a failure.

Garbade examines how the US Federal Reserve originally had the power to directly buy US government debt, and how this was done frequently from 1917 to 1935, in 1942 (during WWII) and some other years too.

Bill Mitchell also notes how Australia (before the 1980s) had a similar “tap” system in which the Australian central bank could directly purchase government bonds from the Treasury.

This is all fascinating and lost history and, as Bill Mitchell notes, the idea that central banks should be forbidden from directly purchasing government debt is a piece of neoliberal fiction. There are clear lessons for today too. We have already seen how indirect central bank purchases of government debt on a large scale can limit government-debt-to-GDP ratios. It would be easier and more effective for central banks to do this directly, especially for nations like Japan where government-debt-to-GDP ratios are already very high.

Saturday, November 22, 2014

At the beginning from 1.17–1.37 minutes of the video Woods makes an extraordinary claim:

“[sc Japan has been] … engaged in Keynesian policy for [sc. a] quarter century now, and, just recently, figures came out for, I guess, GDP growth there, and they were expecting, well, a couple of percentage points positive, and it turns out they keep sinking ever lower.”

This statement (admittedly poorly worded and probably confused) implies that Japanese real GDP has been contracting or falling for 25 years. That is pure nonsense.

Look at the graph below of real Japanese GDP from 1970 to 2011.

Despite its “lost decade,” real GDP continued a long-run rise even in the 1990s (despite a serious austerity-induced recession from 1997 to 1998), and has continued a longer long-run upwards trend for the last 24 years, although the global recession of 2008 to 2009 really hit Japan hard because of its reliance on export-led growth.

Robert Murphy also makes this absurd error and asserts that Japan has “never recovered” from the collapse of its bubble and has been “mired in this rut” – presumably meaning suffering recession or stagnation – for over two decades. Murphy is just ignorant.

Of course, nobody denies that Japan did have serious economic problems in the 1990s and early 2000s in what has been dubbed the “lost decade.” But it recovered from this “lost decade” around 2003–2006. Admittedly, there is also some dispute about when the lost decade ended. Some argue it ended around 2003, while others that it ended about 2006, when positive credit growth returned and deleveraging in Japan’s private sector ended (especially by corporations). That was clearly a sign of much healthier economy and long-run recovery, and it is clearly absurd to claim, as Austrian economists like Murphy do, that Japan has “never recovered” from its 1990s crisis. Of course, Japan also has special problems because it is highly reliant on export-led growth and has a falling population. But these are not directly related to the issue of the asset bubble collapse and crisis of the 1990s.

If we wish to properly understand the “lost decade,” let us look at the history.

In the 1980s, Japan engaged in ill-conceived financial deregulation (Fukao 2003: 134–135), which was one major cause of the asset bubble in these years (although poorly designed tax policies and monetary policy were clearly involved too). The collapse of the asset bubble and the balance sheet recession (a form of debt deflationary crisis) caused the “lost decade.”

Japan’s lost decade involved lower real GDP growth arising from

(1) property price deflation after the collapse of the enormous asset bubble of the 1980s and stock market deflation;

(2) a debt deflation from (1) and from high levels of private debt, and continuing problems as the private sector was overloaded with debt and was weighed down by deleveraging, and

(3) banking problems in which banks were saddled with bad assets and non-performing loans (a crisis that became acute from late 1997).

But the “lost decade” of the 1990s was really an era of low growth, not continuous negative growth.

Many myths have arisen about the lost decade, and one of them is that Keynesianism somehow “failed” to work in this era, as repeated by Murphy and Woods. That is nonsense. If anything, Keynesianism saved Japan from a terrible depression. In fact, when fiscal stimulus was abandoned for austerity in 1997, the economy plunged into a recession.

Japan had mild to moderate Keynesian stimulus packages from about 1993 to 1997 (although the actual fiscal impact of some of the early ones is grossly exaggerated [Posen 1998: 41]), but the result was mild to moderate growth from 1993–1995. In 1996, expansionary policy produced an impressive 3.49% growth rate – much higher than anyone predicted (Posen 1998: 41). (As an aside, I highly recommend Adam S. Posen’s Restoring Japan’s Economic Growth [Washington, D.C. 1998], p. 41f. for analysis of the extent of fiscal stimulus in the 1990s.)

But then from 1997 Prime Minister Ryutaro Hashimoto imposed sharp fiscal contraction and a recession resulted.

A major consequence of the recession induced by fiscal contraction was that the Japanese budget deficit soared by 68% as tax revenue collapsed. This must be counted as one fundamental reason why Japanese public debt soared so badly. When fiscal expansion was applied again on a large enough scale in 1998 the recession ended and growth resumed.

All this is well known in the Japanese press:

“Japan’s first experiment in austerity policies began under Prime Minister Ryutaro Hashimoto (1996–98). Severe spending cuts were seen as needed to rein in budget deficits caused by previous efforts to recover from the 1991 Bubble collapse. Recession followed quickly. Tax revenues collapsed. The national debt increased.

Under Prime Ministers Keizo Obuchi (1998–2000) and then Yoshiro Mori (2000–2001), Japan returned to fiscal expansion policies and the economy recovered rapidly, with the Nikkei Dow share index reaching almost 20,000. But with tax revenues still only in the recovery stage the deficit hawks were able to swoop in once again under Prime Minister Junichiro Koizumi (2001-2006). Austerity in the name of ‘structural reform’ became the order of the day. The Nikkei Dow promptly collapsed to the 7,000 level, tax revenues fell again and the national debt increased by ¥200 trillion in just five years despite the boost to the economy from expanded exports to China and the United States.”Gregory Clark, “Economics of Austerity Don’t Add up,” The Japan Times Online, August 15, 2012.

Japan in the 1990s was somewhat like America in the 1930s. However, Japan differed from the US in that it averted an actual depression, though as in the US its fiscal policy was not applied properly and was then reversed in 1997 in a disastrous error. In the US, Roosevelt reversed his moderate fiscal expansion in 1937, and the US relapsed into depression in 1938. Both 1938 (in the US) and 1998 (in Japan) serve as warnings of the dangers of austerity in a weak economy.

Above all, there was also flawed belief that monetary policy in the form of an experiment with quantitative easing would bring Japan out of deflation, when what was needed was increased fiscal policy.

It is a pity that the lessons of the Japan’s lost decade is forgotten.

On a purely practical note, what should Japan do? First, it should reject contractionary fiscal policy, including tax hikes. A first practical policy is that the Bank of Japan should engage in an aggressive bond-buying program to reduce its government-debt-to-GDP ratio. Further fiscal stimulus should be conducted in a way that stabilises and ideally reduces the government-debt-to-GDP ratio. Banking and financial regulation should be used to stop any further disastrous asset bubbles. Japan’s economy is heavily dependent on export-led growth, and so it should carefully manage its exchange rate to ensure demand for its exports is maintained. In the long-run, Japan needs to encourage more consumption and increase productivity growth. Finally, the 21st century will probably see a revolution as increasingly sophisticated machines such as computers with AI and robots are used in production. Japan is already a high-tech economy and will probably be at the forefront of this revolution. Japan is thus in a good position to increase its productivity growth and address the problems from its aging and falling population. All in all, Japan has reasons for optimism, despite its problems.

In it, he quotes a surprising passage from Human Action (4th rev. edn. 1963) in which Mises says that war by a government in legitimate self-defence and even conscription are justified:

“From this point of view one has to deal with the often-raised problem of whether conscription and the levy of taxes mean a restriction of freedom. If the principles of the market economy were acknowledged by all people all over the world, there would not be any reason to wage war and the individual states could live in undisturbed peace. But as conditions are in our age, a free nation is continually threatened by the aggressive schemes of totalitarian autocracies. If it wants to preserve its freedom, it must be prepared to defend its independence. If the government of a free country forces every citizen to cooperate fully in its designs to repel the aggressors and every able-bodied man to join the armed forces, it does not impose upon the individual a duty that would step beyond the tasks the praxeological law dictates. In a world full of unswerving aggressors and enslavers, integral unconditional pacifism is tantamount to unconditional surrender to the most ruthless oppressors. He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government. The essential task of government is defense of the social system not only against domestic gangsters but also against external foes. He who in our age opposes armaments and conscription is, perhaps unbeknown to himself, an abettor of those aiming at the enslavement of all.

The maintenance of a government apparatus of courts, police officers, prisons, and of armed forces requires considerable expenditure. To levy taxes for these purposes is fully compatible with the freedom the individual enjoys in a free market economy. To assert this does not, of course, amount to a justification of the confiscatory and discriminatory taxation methods practiced today by the self-styled progressive governments. There is need to stress this fact, because in our age of interventionism and the steady ‘progress’ toward totalitarianism the governments employ the power to tax for the destruction of the market economy.

Every step a government takes beyond the fulfillment of its essential functions of protecting the smooth operation of the market economy against aggression, whether on the part of domestic or foreign disturbers, is a step forward on a road that directly leads into the totalitarian system where there is no freedom at all.” (Mises 1996 [1963]: 282).

Even though Mises still condemns what he calls “confiscatory and discriminatory taxation methods practiced today by the self-styled progressive governments,” he still asserts that:

“The maintenance of a government apparatus of courts, police officers, prisons, and of armed forces requires considerable expenditure. To levy taxes for these purposes is fully compatible with the freedom the individual enjoys in a free market economy.” (Mises 1996 [1963]: 282).

And on the subject of war, it is extraordinary to see Mises defend conscription:

“The essential task of government is defense of the social system not only against domestic gangsters but also against external foes. He who in our age opposes armaments and conscription is, perhaps unbeknown to himself, an abettor of those aiming at the enslavement of all.” (Mises 1996 [1963]: 282).

These statements show how far Mises was from the extremist and ridiculous Rothbardian anarcho-capitalists who plague the Austrian movement these days.

Finally, Mises ends with his famously incoherent view that every step a government takes beyond its limited classical liberal “nightwatchman” role is a move towards totalitarianism:

“Every step a government takes beyond the fulfillment of its essential functions of protecting the smooth operation of the market economy against aggression, whether on the part of domestic or foreign disturbers, is a step forward on a road that directly leads into the totalitarian system where there is no freedom at all.” (Mises 1996 [1963]: 282).

“What does ‘interventionist measures logically lead to’ mean? Either Mises believes that interventionism is cumulative and necessarily leads toward socialism and into ‘chaos’ (another undefined term), or he does not. If he does, can he explain how western nations reversed mercantilist intervention and established partially free markets in the 18th and 19th centuries, or how they accomplished partial decontrol after World Wars I and II? Can he explain how the purely free market is ever to be attained? On the other hand, if interventionism need not be cumulative (and Rothbard says it logically leads to the free market as well as to socialism) then is it necessarily incoherent, unstable, and transitory? If interventionism logically points in two opposite directions (toward zero and infinity), does it have to continue in either until it reaches respectively Elysium or chaos?” (Schuller 1951: 190).

We need only think of how there was significant mercantilist intervention in the early modern period in Europe as well as numerous other restrictions on private enterprise. But this period did not end in “chaos” or “socialism” (if by “socialism” we mean a command economy, and not some absurd, nebulous term of abuse that gets applied to every system where government intervention exists). Rather than “chaos” or “socialism,” there was order and mostly orderly reform of economic systems, as, for example, free trade or at least much less restrictive trade was adopted in the 19th century and economies became more laissez faire.

Curiously, it seems that Hayek in regard to his book The Road to Serfdom gets unfairly blamed for the ridiculous, extremist view that in fact was held by Mises. For in The Road to Serfdom Hayek seems to distance himself from Mises, at least by the time of the preface to the 1976 edition:

“The reader will probably ask whether this means that I am still prepared to defend all the main conclusions of this book, and the answer to this is on the whole affirmative. The most important qualification I must add is that during the interval of time terminology has changed and for this reason what I say in the book may be misunderstood. At the time I wrote, socialism meant unambiguously the nationalization of the means of production and the central economic planning which this made possible and necessary. In this sense Sweden, for instance, is today very much less socialistically organized than Great Britain or Austria, though Sweden is commonly regarded as much more socialistic. This is due to the fact that socialism has come to mean chiefly the extensive redistribution of incomes through taxation and the institutions of the welfare state. In the latter kind of socialism the effects I discuss in this book are brought about more slowly, indirectly, and imperfectly. I believe that the ultimate outcome tends to be very much the same, although the process by which it is brought about is not quite the same as that described in this book.

It has frequently been alleged that I have contended that any movement in the direction of socialism is bound to lead to totalitarianism. Even though this danger exists, this is not what the book says. What it contains is a warning that unless we mend the principles of our policy, some very unpleasant consequences will follow which most of those who advocate these policies do not want.” (preface, Hayek, The Road to Serfdom 1976 edn.).

Sunday, November 16, 2014

A statement by Mises in his explanation of labour markets and what causes demand for labour, and in the context of the Great Depression:

“Wage rates are market phenomena, just as interest rates and commodity prices are. Wage rates are determined by the productivity of labor. At the wage rates toward which the market is tending, all those seeking work find employment and all entrepreneurs find the workers they are seeking. However, the interrelated phenomena of the market from which the ‘static’ or ‘natural’ wage rates evolve are always undergoing changes that generate shifts in wage rates among the various occupational groups. There is also always a definite time lag before those seeking work and those offering work have found one another. As a result, there are always sure to be a certain number of unemployed.

Just as there are always houses standing empty and persons looking for housing on the unhampered market, just as there are always unsold wares in markets and persons eager to purchase wares they have not yet found, so there are always persons who are looking for work. However, on the unhampered market, this unemployment cannot attain vast proportions. Those capable of work will not be looking for work over a considerable period—many months or even years—without finding it.” (Mises 2006 [1931]: 164–165).

This view is hardly unique to Austrian economics of course; many streams of neoclassical theory think labour demand is wholly or mainly a function of the wage rate (and this is why they are obsessed with labour market deregulation and wage flexibility).

The trouble is: it is not true. That is to say, the main cause of demand for labour is aggregate demand for output, and wages rates are very much a secondary phenomenon. Of course, nobody denies that if wage rates get too high, it will probably reduce demand for labour, or that in some markets wage rates might be the determining factor. But in most markets wages are relatively inflexible downwards, and a high degree of wage stickiness is a persistent and omnipresent characteristic of modern advanced economies.

But it is worse than this, because there is a great deal of evidence that even managers and capitalists often dislike pay cuts. Recent studies suggest that employers avoid pay cuts because they diminish workers’ morale, and then falling morale reduces productivity, amongst many other reasons (Bewley 1999; see a nice summary of Bewley’s work on wages here). There is even evidence that by the late 19th century downwards nominal wage rigidity was already a serious fact of life in the American manufacturing sector (Hanes 1993). This type of significant wage stickiness has clearly been around for a long time, and certainly it existed in the golden age of capitalism (1946–1973), yet in that period unemployment was historically low and it was not due to wage rates adjusting rapidly to allegedly clear labour markets.

Even when demand shocks are severe enough to cause wage and price deflation (as in the early 1930s), in an environment of high private debt, this would cause a severe debt deflationary crisis in a capitalist economy.

Mises’ “unhampered market” is a fantasy world of little relevance to an empirical economics, and the central element in it – that wage rates would be the primary determinant of demand for labour and would be flexible enough to ensure that involuntary unemployment never reaches significant levels – is hardly credible as a condition that we would see in the real world.

Hanes, Christopher. 1993. “The Development of Nominal Wage Rigidity in the Late 19th Century,” The American Economic Review 83.4: 732–756.

Mises, Ludwig von. 2006 [1931]. “The Causes of the Economic Crisis,” in Percy L. Greaves (ed.). The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala.

Saturday, November 15, 2014

There is a curious tendency in economics to define “interest” as what is commonly called “profit”: the return to capital used in production.

In neoclassical theory, the long-run equilibrium, uniform rate of profit, usually understood as the marginal productivity of capital or the “natural rate,” is seen as the anchor of the system and the variable that governs and determines the money rate of interest in the long run (Pivetti 2012: 475), even if in the short run the money rate of interest can deviate from the natural rate. The “natural rate” is usually thought to be the rate that ensures price stability as well, as in the New Consensus Macroeconomics and its “Taylor Rule” (Pivetti 2012: 475–476).

The trouble with this of course is that you can’t have a long-run, uniform rate of profit in disequilibrium: it is only in a long-run equilibrium that such a thing could exist. In the real world of disequilibrium, there are many changing rates of return in thousands of industries, and in a world of uncertainty, severe barriers to entry in many markets and imperfect competition, there is no reason to think they will converge to a uniform rate even in the long run.

So how on earth can New Consensus Macroeconomics monetary policy be justified?

To its credit, the New Consensus Macroeconomics now recognises that money supply is endogenous (Pilkington 2014: 3). It also recognises that the central bank sets the money rate of interest, while the actual money supply “floats” (Pilkington 2014: 3). It is now accepted that it is the monetary interest rate that is the relevant “real policy target of the central banks” (Pilkington 2014: 4).

As Philip Pilkington points out,

“the Taylor Rule, when integrated into new consensus macro models, implicitly assumes that there exists a natural rate of interest which the central bank can target in order to generate both full employment and relative price stability. This natural rate is assumed to be the rate below which there will be a substantial trade-off between inflation and real output (i.e., if real output accelerates so too will inflation). This, of course, is familiar to many as the natural rate of interest, as sketched out by Knut Wicksell (Wicksell, 1898), and this is the reason why the natural rate has received renewed interest at central banks.” (Pilkington 2014: 4).

At any rate, the relevant Wicksellian definition is found in Lectures on Political Economy. Volume 2: Money (1935):

“The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yield on the newly created capital, will then be the normal or natural real rate. It is essentially variable.” (Wicksell 1935: 192–193).

A similar definition also appears in Wicksell’s article “The Influence of the Rate of Interest on Prices” (1907):

“According to the general opinion among economists, the interest on money is regulated in the long run by the profit on capital, which in its turn is determined by the productivity and relative abundance of real capital, or, in the terms of modern political economy, by its marginal productivity. (Wicksell 1907: 214).

In modern New Consensus Macroeconomics, the natural rate (which is also sometimes called the “neutral rate”) is seen as the interest rate that

(1) equates saving and investment at full employment, and

(2) also ensures prices stability.

New Consensus Macroeconomics monetary policy – through the Taylor Rule – requires that there exists such a natural rate, which the central bank can target, and which is a reliable tool for achieving full employment and price stability.

As we have seen, this “natural rate” is clearly the modern descendent of the Wicksellian “natural rate” and Wicksell’s attempt to reformulate the quantity theory to be consistent with endogenous money (Pilkington 2014: 5).

Keynes, however, rejected “the natural rate” concept as the long-run determinant of monetary interest rates, and developed his liquidity preference theory of interest; Keynes also argued that the “level of employment is ultimately determined by the level of investment” (Pilkington 2014: 5–6).

Keynes’ insights have been rejected, and modern neoclassical economics has returned to the Wicksellian loanable funds theory.

However, we live in a world of disequilibrium. Given the non-existence of a present long-run, uniform rate of profit that is the “natural rate” anchor for the central bank, how can New Consensus Macroeconomics monetary policy be coherent? Even if a market economy had a real long-run tendency to a uniform rate of profit that is the “natural rate,” how could a central bank possibly know that rate? Of course, if there is no convincing reason to think that real-world market economies converge towards a long-run general equilibrium state, the whole notion that there is some hypothetical natural rate that might be a central bank target is untenable.

So how can the advocates of the New Consensus Macroeconomics defend their monetary policy? Again, as argued by Philip Pilkington,

“For Wicksell’s theory to be coherent when the notion of risk is taken into account, every specific interest rate in the economy must be set in a rational manner in line with the level of objective risk that must be given to each investment project. There must thus be a different natural rate of interest for each investment project, which reflects its true underlying risk relative to its return. Even if the central bank can set the money rate in line with something resembling a natural rate of interest—perhaps they might set it in line with the lowest risk investment projects’ natural rate—the capital markets will still have to line up all the other rates of interest on various heterogeneous projects with their specific natural rates. So, in order for Wicksell’s theory to hold, each interest rate must be set in line with the central bank money rate of interest plus a markup premium that takes full account of the objective risk of the capital project underlying this specific rate of interest relative to its objective return. This view of the capital markets can be summarized as that of the [efficient markets hypothesis] … . Investors/savers have access to perfectly clear knowledge of potential investments. Thus, they view potential investments as a series of given objective probabilities and they assign these probabilities a price—a required yield or rate of interest—that is inversely proportional to the risk of the investment not paying off.” (Pilkington 2014: 9).

Under such a condition,

“At equilibrium, we can assume that all information is being reflected in financial market prices and thus that all interest rates are aligned with their particular natural rate. The equilibrium point ..., if applied to the market as a whole, can be thought of as a whole series of natural rates of interest that will balance the economy at the optimum level of full employment output. This series of interest rates, if arrived at by the capital markets, will generate a stable equilibrium growth path with no inflation or deflation.” (Pilkington 2014: 10).

But this is completely and utterly unrealistic: it requires perfect information, no fundamental uncertainty and the untenable efficient markets hypothesis to be remotely credible. In reality, interest rates are set under uncertainty by liquidity preference and “set in line with that asset’s perceived riskiness and the level of risk aversion that the investment community holds at any given moment in time” (Pilkington 2014: 11).

In conclusion, we can see how New Consensus Macroeconomics monetary policy requires rational expectations, perfect foresight, perfect knowledge and the efficient markets hypothesis. None of these things is remotely realistic and New Consensus monetary policy, with its emphasis on a modern version of the natural rate, cannot be taken seriously.

Thursday, November 13, 2014

In what follows I give a brief overview of Alfred Marshall’s development of the quantity theory in the late 1800s on the basis of the discussion in Laidler (1991).

In Classical Political Economy, the long-run value of gold money was thought to be determined by the cost of production of gold (Laidler 1991: 51). It was only in the short-run that the quantity theory was used to explain the value of money and hence the price level (Laidler 1991: 51).

Curiously, the quantity theory of money was deployed by bimetallists and opponents of the gold standard in the 1873 to 1896 period (Laidler 1991: 50). This use of the quantity theory by bimetallists actually caused the quantity theory to be brought into some disrepute in this period, and advocates of the gold standard and sound money started to look on it with some suspicion (Laidler 1991: 52).

Alfred Marshall actually sketched an early version of the Cambridge Cash Balance Equation in an unpublished paper of 1871 called “Money” (Marshall 1975 [1871]), and later in his paper “Remedies for Fluctuations in General Prices” (Marshall 1887), and in his testimony before the British “Royal Commission on the Value of Gold and Silver” (1888–1889) and the Indian Currency Committee (1899) (Laidler 1991: 53). Hence before the early 20th century Marshall’s teachings on the quantity theory were mainly oral (Laidler 1991: 53). Marshall did, however, publish his views late in life in his book Money, Credit and Commerce (1923).

We can set out the published sources of the early Marshallian quantity theory tradition, as follows (in chronological order):

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.

Keynes, J. M. 1911. Review of The Purchasing Power of Money: Its Determination and Relation to Credit, Interest, and Crisis by Irving Fisher, Economic Journal 21.83: 393–398.

Marshall’s 1871 paper “Money” was a basic statement of his teaching right down to 1906 (Laidler 1991: 56).

Marshall inherited the quantity theory from Classical economics, and in particular from John Stuart Mill’s writings (Laidler 1991: 54). But Marshall introduced the stock demand for money into consideration as a determinant of money’s value, and downgraded the importance of commodity money’s cost of production as a factor determining its value (Laidler 1991: 54–55).

In explaining the price level, a greater emphasis was put on variations in the demand for currency by the Marshallians (Laidler 1991: 56).

Marshall also understood the limitations of the ceteris paribus assumption in the quantity theory and thought that factors other than money supply changes were probably more influential in causing price level changes:

[sc. Question:] 9629. To pass now to the question which has been raised of the dependence of prices upon the quantity
of the currency, what observations have you to make? …

[sc. Marshall’s answer:] I accept the common doctrine that prices generally rise, other things being equal, in proportion to the volume of the metals which are used as currency. I think that changes in the other things which are taken as equal are very often, perhaps generally, more important than the changes in the volumes of the precious metals.A question was asked by the Commission some time ago as to the dependence of prices upon the amount of the precious metal which was used as the standard of value. I object to make any such distinction. I believe that the shillings and half-crowns in circulation have just the same effect upon prices as they would have if they were legal tender; I believe that four half-crowns affect prices exactly in the same way as a half sovereign does. But putting that aside, I think that we have not the statistics, and that we shall not, in this generation, be able to get the statistics which would enable us to trace any statistical connexion between the amount of the precious metals, or, as I would prefer to say, between the amount of currency and the average level of prices; because, supposing that the volume of the currency remains the same, the height of average prices may yet vary in consequence of several causes. The first of these is a change in the volume of things on sale, and with regard to that no doubt we have fairly good statistics. The second is an increase or diminution in the average number of times each of these things changes hands during the year, and with regard to that we have no statistics whatever; indeed, there has never been any attempt to obtain statistics on the subject. The third cause is the average number of times that each coin or each element of the currency changes hands during the year; on that subject also there are no statistics. The last cause is the proportion which purchases otherwise than by currency bear to purchases by means of currency; on that subject I think we have no statistics which are in the least trustworthy, although, of course, a great many people have given guesses of more or less value. It seems to me that it is an insufficient account to say that average prices depend on the amount of the currency combined with the amount of credit. For without any change in the amount of the currency the average level of prices might be altered, not only by a change in the proportion of credit to other means of purchasing, but also by any other change in the methods of business, as for instance the growth of intermediaries.”
Alfred Marshall’s testimony, Minutes of Evidence taken before the Royal Commission on Gold and Silver. Forty-third Day, 19th December 1887 in Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. p. 2.

Laidler notes that Marshall and the Cambridge Marshallians eventually de-emphasised and abandoned the velocity of circulation concept as an important concept in the quantity theory (Laidler 1991: 59). Instead, the important concept was the money people choose to hold as a stock (Laidler 1991: 59), or the cash balance which would become the variable k in the Cambridge Cash Balance Equation.

BIBLIOGRAPHYFinal Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.
https://archive.org/details/cu31924030184745

Keynes, J. M. 1911. Review of The Purchasing Power of Money: Its Determination and Relation to Credit, Interest, and Crisis by Irving Fisher, Economic Journal 21.83: 393–398.

Laidler, David E. W. 1991. The Golden Age of the Quantity Theory: The Development of Neoclassical Monetary Economics 1870–1914. Harvester Wheatsheaf, New York and London.

In essence, Robert Murphy reproduces a quotation from a column by Martin Wolf, the British journalist and chief economics commentator at the Financial Times.

In his Mises Canada post, Murphy makes the astonishing claim that Martin Wolf is using an analysis of the causes of business cycles that is “thoroughly Austrian”:

“Now to be sure, Wolf is still a Keynesian in his prescriptions: he wants more monetary and fiscal stimulus. But my point with this post is to show that his diagnosis is thoroughly Austrian. Guys like Larry Summers and (yikes!) Paul Krugman, with their “secular stagnation” hypothesis, are also coming around to the view that Western economies have been bouncing from bubble to bubble, fueled by central bank policies.

Neither in the article in question nor in the rest of his writings does Wolf endorse the Austrian business cycle theory (ABCT). The most positive thing that Wolf has ever said about the ABCT (to my knowledge) was on his Financial Times blog, where he stated that he had “sympathy with” some of the ideas in the ABCT but ultimately rejected it (see Wolf 2010). Clearly, Wolf is not saying banks or a central bank are driving a money rate below the natural rate of interest, and thereby inducing an “unsustainable” lengthening of the capital structure. Wolf is pointing to poorly regulated financial markets and asset bubbles as a driving, destabilising force of modern business cycles, as well as debt deflation and debt overhang in the bust and aftermath, but these things never had a fundamental role in the classic ABCT writings of Mises, Hayek or Rothbard.

Martin Wolf actually takes a maverick heterodox Keynesian/Post Keynesian explanation of the crisis, and even invokes Hyman Minsky’s theories in his writings. In fact, in Martin Wolf’s recent book The Shifts and the Shocks: What We’ve Learned – and Have Still to Learn – from the Financial Crisis (Wolf 2014) Wolf commits himself partly to a Post Keynesian analysis, and explicitly endorses Hyman Minsky’s theories (unfortunately he also endorses the global savings glut thesis, which is not generally endorsed by Post Keynesians).

Right in the preface of his book, Wolf notes that there is a superficial similarity between Austrian and Post Keynesian analyses, but profound differences in their explanations of both the causes of and solutions to the crisis (Wolf 2014: xvii).

It didn’t take long for “Major_Freedom” – the most stupid and ignorant commentator on Murphy’s blog – to defend him with a typically desperate and absurd explanation:

“Murphy’s only argument, which is valid and you have not at all refuted or even challenged in your accusations, retractions and rescues, is that the section Murphy quoted, which is a largely self-contained argument, is indistinguishable from textbook, traditional ABCT.”
http://consultingbyrpm.com/blog/2014/11/martin-wolf-closet-austrian.html#comment-1260131

At first I didn’t think Murphy would actually sink so low as to defend himself in these terms, but – lo and behold! – it seems I overestimated him.

In his subsequent explanation of his purpose in the post in the comments on his blog, Murphy uses that defence:

“You’re right ... [Major_Freedom], my point was that Wolf was indistinguishable from Austrians in his diagnosis, in that column.”
http://consultingbyrpm.com/blog/2014/11/martin-wolf-closet-austrian.html#comment-1260153

Actually, Martin Wolf’s analysis in his original column is not “indistinguishable from Austrians” at all: it is mostly concerned with the macroeconomic effects of deleveraging and the debt overhang since 2008, and argues that many nations need to bring down private debt levels, reform and recapitalise banks, and implement strong fiscal stimulus.

All one can say to defend Murphy’s position is that only if we

(1) cite a selective quotation from Wolf, and

(2) take the quotation out of context, and

(3) ignore Wolf’s actual beliefs and all his other writings on the causes of business cycles,

then we can just pretend that Martin Wolf’s explanation of the current crisis is “thoroughly Austrian.”

This just stinks of a lazy unwillingness to actually engage with what Wolf or heterodox Keynesians actually think. If you can selectively quote your opponents and ignore what your opponents actually think, then you can pretend that your opponents agree with you. But it is a tactic that is profoundly intellectually dishonest.

Tuesday, November 11, 2014

A classic statement from John Venn’s The Logic of Chance (1876) about a fundamental problem in philosophy of probability, the reference class problem:

“We must now shift our point of view a little; instead of starting, as in the former chapters, with a determinate series supposed to be given to us, let us assume that the individual only is given, and that the work is imposed upon us of finding out the appropriate series. How are we to set about the task? In the former case our data were of this kind:—Eight out of ten men, aged fifty, will live eleven years more, and we ascertained in what sense, and with what certainty, we could infer that, say, John Smith, aged fifty, would live to sixty-one.

§ 12. Let us then suppose, instead, that John Smith presents himself, how should we in this case set about obtaining a series for him? In other words, how should we collect the appropriate statistics? It should be borne in mind that when we are attempting to make real inferences about things as yet unknown, it is in this form that the problem will practically present itself.

At first sight the answer to this question may seem to be obtained by a very simple process, viz. by counting how many men of the age of John Smith, respectively do and do not live for eleven years. In reality however the process is far from being so simple as it appears. For it must be remembered that each individual thing has not one distinct and appropriate series, to which, and to which alone, it properly belongs. We may indeed be practically in the habit of considering it under such a single aspect, and it may therefore seem to us more familiar when it occupies a place in one series rather than in another; but such a practice is merely customary on our part, not obligatory. It is obvious that every individual thing or event has an indefinite number of properties or attributes observable in it, and might therefore be considered as belonging to an indefinite number of different classes of things. By belonging to any one class it of course becomes at the same time a member of all the higher classes, the genera, of which that class was a species. But, moreover, by virtue of each accidental attribute which it possesses, it becomes a member of a class intersecting, so to say, some of the other classes. John Smith is a consumptive man say, and a native of a northern climate. Being a man he is of course included in the class of vertebrates, also in that of animals, as well as in any higher such classes that there may be. The property of being consumptive refers him to another class, narrower than any of the above; whilst that of being born in a northern climate refers him to a new and distinct class, not conterminous with any of the rest, for there are things born in the north which are not men.

When therefore John Smith presents himself to our notice without, so to say, any particular label attached to him informing us under which of his various aspects he is to be viewed, the process of thus referring him to a class becomes to a great extent arbitrary. If he had been indicated to us by a general name, that, of course, would have been some clue; for the name having a determinate connotation would specify at any rate a fixed group of attributes within which our selection was to be confined. But names and attributes being connected together, we are here supposed to be just as much in ignorance what name he is to be called by, as what group out of all his innumerable attributes is to be taken account of; for to tell us one of these things would be precisely the same in effect as to tell us the other. In saying that it is thus arbitrary under which class he is placed, we mean, of course, that there are no logical grounds of decision; the selection must be determined by some extraneous considerations. Mere inspection of the individual would simply show us that he could equally be referred to an indefinite number of classes, but would in itself give no inducement to prefer, for our special purpose, one of these classes to another. This variety of classes to which the individual may be referred owing to his possession of a multiplicity of attributes, has an important bearing on the process of inference which was indicated in the earlier sections of this chapter, and which we must now examine in more special reference to our particular subject.” (Venn 1876: 194–195).

What is the problem here?

The problem is closely related to probability theory. What, for example, is the probability that some particular person John Smith will contract cancer in his lifetime? Is there a fixed, objective, numeric probability that we can give? Some would say: yes. Can’t we just look at the frequency of how many people get cancer of the whole national population of the country where John Smith lives?

Let us imagine that John Smith lives in the UK. According to statistical data, a UK citizen will have at least a 1 in 3 chance of being diagnosed with one of the many forms of cancer during his or her lifetime. The crucial class is: the class of those people who are diagnosed with cancer of all the UK population.

So is there a fixed, objective, numeric probability of at least 1 in 3 that John Smith will contract cancer during his lifetime? On closer inspection, however, this does not necessarily seem to be right. Some people have a much greater risk of developing cancer than other people, on the basis of genetics and environmental influences like their incidence of smoking, excessive alcohol consumption and exposure to carcinogenic substances.

Immediately, we can identify further, narrower reference classes to which John Smith might belong and which would change the probability of his being diagnosed with cancer.

Let us consider the reference classes one by one, and imagine we know many details about John Smith:

(1) the population of the UK;

(2) the class of people who develop cancer in the population of the UK;

(3) the class of male people who develop cancer in the UK (since John Smith is a man);

(4) the class of non-smoking male people who develop cancer in the UK (since John Smith is a non-smoker);

(6) the class of non-smoking, male people who do not drink alcohol and who develop cancer in the UK (since John Smith does not drink);

(7) the class of non-smoking, male people who do not drink alcohol and who are not exposed to known carcinogenic substances in the workplace and who develop cancer in the UK (since John Smith has a job where he is not exposed to known carcinogenic substances);

(8) the class of non-smoking, male people who do not drink alcohol and who are not exposed to known carcinogenic substances in the workplace and who do regular exercise and who develop cancer in the UK (since John Smith does regular exercise).

If we were to look at the class of people in class (8), then we can calculate a statistical probability.

But the trouble is: this is not even an exhaustive list! Can we really obtain a fixed, objective, numeric probability if we keep adding narrower reference classes and finally get to a point where we stop? Even here there is a crucial problem: the uncertainty of the future. Whatever probability obtained may well be overturned in the future, so that it can hardly be said to be objectively fixed in the long run in the way that the probability of rolling 6 in a fair game of die is actually fixed at 1 in 6 and becomes closer to this probability in the long run.

Say, some new, preventive drug is developed in 4 years which cuts one’s risk of developing cancer by 60%, and John takes the drug. Suddenly his probability of developing cancer has to be radically revised.

Say, John has an undiagnosed genetic disorder that modern science cannot identify that makes it 100% certain that he will develop cancer. Here the statistical probability, even in the narrowest reference class, will be wrong and clearly not an objective, numeric probability, because we have missed a fundamental fact about John.

We can quickly see the difficulties that the reference class problem gives rise to, and how it can render statistical probabilities problematic. Of course, I do not want to suggest that statistical probabilities are useless: clearly they are not, and they can be very useful.

But we should be aware of the limitations of statistical probabilities too, and how some may just give us the illusion of objectivity.

BIBLIOGRAPHY
Venn, John. 1876. The Logic of Chance: An Essay on the Foundations and Province of the Theory of Probability, with Especial Reference to its Logical Bearings and its Application to Moral and Social Science (2nd rev. edn.). Macmillan, London.

Sunday, November 9, 2014

In an interesting interview below, James Galbraith speaks on the role of government, the way it can be captured by the private sector, but also how it can play a crucial role in regulation and supporting the private sector.

Saturday, November 8, 2014

Frederick Lavington (1881–1927) was a minor Marshallian economist. He began study at Cambridge as a mature student in 1908 (Groenewegen 2012: 100) and graduated from Cambridge in 1911 with a degree in Part II of the Economics and Politics Tripos; he worked in the British Board of Trade from 1912 to 1918, and became a lecturer in economics at Cambridge in 1918, but died early in 1927 (Groenewegen 2012: 99).

His work is of some interest in that he raised issues about fundamental uncertainty in relation to economic life, and may have anticipated Keynes to some limited extent.

Lavington’s article “Uncertainty in its Relation to the Net Rate of Interest” (1912) has some interesting analysis of uncertainty in business life. Lavington defined uncertainty as a type of “ignorance” but also a form of “imperfect knowledge” (Lavington 1912: 400), so it is not clear that he understood the finer points of radical uncertainty. Nevertheless, Lavington also argued that uncertainty can badly affect investment and prevent capital investment happening (Lavington 1912: 401).

In a fascinating analysis, Lavington notes how societies can reduce uncertainty both through government interventions such as the provision of police services and law and order and by private market arrangements such as joint stock companies, speculators as intermediaries, and insurance companies (Lavington 1912: 401). Above all, business people deal with uncertainty by holding money as “reserve fund” to insure against an uncertain future (Lavington 1912: 401–402). As Keynes would have said, money can be held as a “hedge” against uncertainty, and this is an important insight.

In short, the work on uncertainty by Lavington can be seen as a sort of precursor to the later insights of Keynes.

With its talk of the zero “lower bound” and monetary policy as an effective way to control inflation too (when it is not), the analysis clearly has the feel of New Keynesian economic theory, rather than heterodox Keynesianism.

Wednesday, November 5, 2014

A succinct statement here, even though Rothbard does not use the expression “natural rate”:

“The willingness of the firm’s owners to pay a fixed-interest return to lenders is, of course, a function of their anticipated profit in selling the product to the consumers. Willingness to pay interest will always be less than or equal to the anticipated profit rate; and in the long-run general-equilibrium world of changeless certainty—a world that has never and can never come into existence—the rate of return would be equal throughout the market economy. In that world, the rate of profit in every firm would be equal to the rate of interest on loans.” (Rothbard 2011: 451).

This is very much a version of the Wicksellian monetary equilibrium approach, where the “rate of return” in long-run general-equilibrium is equal to one version of Wicksell’s natural rate, and in turn the rate of return on capital is equal to the rate of interest.

Rothbard notes that only in “long-run general-equilibrium” can the rate of return be uniform: consequently it follows from this that only in such an equilibrium can there be a single natural rate.

Yet, despite this, Rothbard just blathers on about the single “natural rate” when he discusses the Austrian business cycle theory (ABCT) (Rothbard 2009: 794, 1003–1004), and sees no contradiction when he bases the whole ABCT on the idea of central banks and credit expansion driving the money rate below the single natural rate. If nothing else, this proves how incoherent and intellectually incompetent Rothbard’s version of the ABCT was, just as the earlier versions of Hayek and Mises.

At one point Rothbard (2009: 1003, 112) even claims his version of the “natural rate” is different from Wicksell’s, but he seems ignorant of the fact that Wicksell had two definitions of the “natural rate,” and Wicksell did sometimes define it as the “expected yield on the newly created capital” (Wicksell 1935: 192–193) or the long-run “profit on capital” (Wicksell 1907: 214).

The Marshallian tradition gave rise to Keynes, and in some ways it was less extreme, more realistic and more pragmatic than its the Walrasian cousin. For these reasons, the Marshallian tradition is worthy of serious study.

So who were the neoclassical economics working in the tradition of Alfred Marshall? This is a tentative list below with the major Marshallians in bold:

Of course, Keynes came to repudiate major aspects of even the Marshallian tradition when he published the General Theory, which is in many ways a rebellion against neoclassical Marshallian economics, and so too did Keynes’ followers like Joan Robinson.

Monday, November 3, 2014

We can start with Alfred Marshall’s statement on 19 December 1887 to the British “Royal Commission on the Value of Gold and Silver” (edited for clarity):

[sc. Question:]“9651. The evidence that has been put by some witnesses before us has been intended to show that so far from any connexion being traceable between plentiful money and a low rate of discount and a plentiful supply of the precious metals, the evidence was just the other way?

[sc. Marshall’s answer:] Oh yes, that is certainly true as regards permanent results; the supply of gold exercises no permanent influence over the rate of discount. The average rate of discount permanently is determined by the profitableness of business. All that the influx of gold does is to make a sort of ripple on the surface of the water. The average rate of discount is determined by the average level of interest in my opinion, and that is determined exclusively by the profitableness of business, gold and silver merely acting as counters with regard to it.”
(Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. p. 4).

The “rate of discount” is Marshall’s expression for the money rate of interest. But, for Marshall, in the long-run the money rate of interest is determined by the “real” rate of interest, which is in turn determined by the demand and supply of real capital goods (Bridel 1987: 38): the “real” rate concept is analogous to Wicksell’s natural rate of interest.

But of course, for Marshall, variations in supply of gold can cause short-run changes in the money rate of interest.

In fact, Marshall saw four factors that could influence the money rate of interest, as follows:

(1) changes in the supply and demand for real capital;

(2) changes in the supply of commodity money;

(3) changes in the supply of money available for lending in the banking system, and

If the supply of gold increases, for example, then this will induce excessive demand for real capital goods and price inflation, according to Marshall (Bridel 1987: 41), and if there is an expectation of further prices rises there might be a cumulative process of inflation as further investment occurs (Bridel 1987: 41–42). This process is a short-run phenomenon. Eventually banks will raise money rates of interest and a new equilibrium will be reached as money rates rise to equal the long-run “real” rate (the functional equivalent of the natural rate) (Bridel 1987: 42).

Bridel (1987: 43) argues that Marshall missed the idea of “forced saving” and the latter insights of Keynes in the Treatise on Money (1930), that a contraction of consumption induced by forced saving lowers the marginal productivity of capital and hence lowers the natural rate of interest.

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.